I Just Doubled My Salary – What Do I Do With The Money?

A reader (let’s call him Ralph) wrote in with the following interesting situation (that has some parallels to my own):

About a year ago my wife and I bought a new house with no money down and a 30 year fixed rate mortgage locked in at 5.5%. This meant of course that we would be paying PMI for the first twelve years or so of the mortgage assuming the value doesn’t go up.

About a month ago, I switched jobs and literally doubled my salary. We have no intentions of changing our lifestyle at all and we plan on just investing the extra income but we are trying to decide what to do with it. Should we use it to pay off our mortgage above everything else? Should we invest it? Should we just pay it off down the PMI rate and then invest it?

We both have student loans that are around 4% but no other debts at all.

Ralph is in a pretty exciting situation that’s going to open a lot of doors for him in the long run. Suddenly, he’s in a position to start saving 80% or so of his previous take-home pay, which is going to make an enormous difference in the long run. Plus, they have no credit card debt, which would be the first major obstacle to overcome. They’re really in great shape here.

First of all, I would build up a nice hefty emergency fund, probably as much as six months’ worth of take-home. Given that you’re intending to live on your previous take-home, I would just have the fund include that amount plus your wife’s take-home. Put this money in a savings account that earns 5% APY (like HSBC Direct) and just let it sit there to protect you against a rainy day.

Second, I would pay the house mortgage down to 78% and get off the PMI. PMI averages around 0.5% of the value of the mortgage each year with no real return, and by accelerating the payments you can get out of PMI pretty quickly (just a few years), giving yourself several years where you don’t have to pay the PMI that you would have to if you didn’t pay ahead. This can net you 5% of your mortgage value. Even if you’re tempted, though, don’t stuff the emergency fund in here to get it over with, because I’ve seen time and time again that when I use my emergency fund to get something paid off, I need that fund the very next day.

After that, spend some time figuring out what your goals are. For some people, it is being completely debt free, so if that’s the case, focus on paying down your highest interest debt (in this scenario, your house) and then follow it with lower interest debt. You may also want to sock cash away so that you can pay cash for an automobile purchase (put the cash in a high-interest savings account until you’re ready to just write a check for the automobile). Investing is another option at this point – start building an investment portfolio, but know what your goal with the money is before you start (retiring early, building a dream home, etc.).

In short, if you’re actually committed to using the extra money to get yourself on a solid financial plane, the ability to use 80% of your salary solely for this purpose will help quite a lot. Good luck!

Gotta disagree on paying down the house. The loan after deductions is being given to you at 3%. Paying all that money down (into the walls) just to save 0.5% isn’t that great. Stick it in a mutual fund instead and get 8%. If you have an emergency you don’t need to borrow against your house (and pay someone else 8% to get your money back) to get access to it. And if you don’t have an emergency use the dividends to help pay your mortgage. Over time your investment will eventually pay more and more of the mortgage and still be available for you. In theory. We did this and had an emergency so we are spending the money on that.

In the walls the return is fixed (on getting rid of the interest – no small potatoes to be sure.

I agree with part of what you said — building up an emergency fund and getting rid of PMI because that is an unnecessary expense. Paying down the mortgage in general though — at 5.5%? What about saving for retirement, your children’s education (if this applies), or finding other investments with returns >5.5%? It does sound goals need to be revisited — but with the larger financial picture in mind.

Best advise given here is to “spend some time figuring out what your goals are”. The best answer is often not defined in numbers. It is what provides the most peace of mind and best nights sleep.

Two other points… 1) no mention of charitable intent. This person should consider what charitable causes (if any) they want to champion… 2) In regards to Trent’s comment, cost basis in a Roth can be withdrawn without penalty or taxes. It is not a good idea, but it is an option all the same.

I second Trent, tax deductions don’t make mortgage payments and the stock market doesn’t return 8% a year it loses 25% one year and maybe gains a few years latter 50%. Having no payments is the best return one can get. Just ask all the people who are losing there homes to the subprime mess.

I also think the advice to spend time figuring out goals is the most important thing here. Its a corollary of the answer to every personal finance question, “it depends”. What ‘Ralph’ should do depends on what ‘Ralph’ wants out of life.

Personally, I’d want to ensure a secure retirement, short-term savings for fun stuff like travel, and donating to charity. This may or may not include paying the house off early. But then I’ve no desire to be rich but to retire comfortably instead.

I can tell Ralph how I’ve prioritized my saving & maybe it’ll give him some ideas.

When reading this keep in mind that I’m in my early 40’s, don’t have children, have 11 years to go on my mortgage, work for a company with a 401K, and am relatively risk & debt averse.

And I assume Ralph doesn’t have any debts (other than the new mortgage)–

#1. If you work for a company with a 401K and they match some of your contribution, make sure you are putting enough (if not more!) into your 401K to at least get that match.

#2. Emergency saving is a must — in addition to saving for home upkeep, improvement & repairs (sock away 1-3% of the value of your home each year — that way you have the $500 when your hot water heater explodes, and you don’t have to take out a $5,000 home equity loan when your roof needs replacing).

#3. Got kids? Saving for their college educations could be on your list.

#4. From the start, we paid extra principal on our mortgage because I figured it would save us money in the end, and we’d own our house sooner (for an extra full payment every year I figured we’d cut 5-7 years off our original 30 year mortgage). I definitely want to own our house free & clear well before retirement.

We refinanced 4 years ago — 5%/15 years, which lowered our monthly payment & I’ve sort of slacked off on the extra principal payments because I know the house will definitely be paid off before I’m 50 (and also because I was bad & bought a new car).

As for the tax deduction for mortgage interest — after the first 6 years, the interest deduction didn’t matter any more for tax purposes for us — taking the standard deduction has turned out to be greater than itemizing for the past 8 years.

#5. Roth IRA — if you qualify, get one for you and one for your wife & fully fund both of them every year. If you don’t have a retirement savings plan at work (or a traditional pension), this would move to the top of the list.

#6. Charity — I love the fact that Art mentioned donating to your favorite charities! And check to see if the company you work for matches certain charitable contributions.

#7. And if there’s something you’ve always wanted — a vacation to some place special, a car, whatever — you’re in a position to save for that now as well.

Regarding the ROTH IRA your comment is a little misleading. You will lose important tax benefits if you tap into your Roth IRA but you will have immediate access (penalty free with no taxation on distribution since you already were taxed originally) since you are allowed to withdraw (contributions only though) at any point in time for any reason.

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